Bill Oxford
Verizon (NYSE:VZ) leads a highly competitive utility segment – wireless and wired telecommunications. As the Frankenstein child of old Ma Bell, Verizon merged several Baby Bells with other competitors to construct the leading wireless carrier in the U.S. Once again in 2022, VZ was voted the best wireless network across all six US regions in 2022 in the annual J.D. Power survey.
Typically, utilities are natural monopolies that require government regulation to ensure fair pricing. When Congress broke up the old AT&T (T), they created a fiercely competitive landscape with many players eventually overlapping each other’s service areas. Further complicating the picture, wireless and internet connectivity services completely transformed telecommunications from a dowdy, steady revenue generator into a tech-driven competition for wireless spectrum and durable infrastructure that requires gobs of capital investment.
Today, VZ primarily competes with AT&T and T-Mobile (TMUS) – a carrier controlled by Deutsche Telekom (OTCQX:DTEGY) – across wireless customers and some wireline customers (TMUS sold its wireline business after the Sprint merger).
The market divides roughly into the following major segments:
- Wireless Business;
- Wireless Consumer;
- Wireline Business; and
- Wireline Consumer.
There are other sub-categories like prepaid services, equipment sales, wholesale sales, etc. While we do have some detail, they are not where the action is. The big action is coming in the C-Band (the mid-band of the 5G spectrum) rollout over the next few years.
Under The Hood
Verizon’s business model is basically a subscription model with an equipment provider. While customers can provide their own equipment, wireless carriers prefer to provide customers specifically tuned wireless devices for two reasons: (1) tighter network integration, app provisioning and overall bundling, plus (2) it increases the switching costs for customers to leave the network (reduces customer churn).
Recurring Revenue Model
While equipment is a critical part of the business, its revenues do not drive profits so much as create marketing opportunities to bring new (and retain existing) customers through subsidized equipment offers that keep them on the network for years.
More importantly, subscription businesses depend on long-tailed recurring revenue streams to offset high initial marketing costs like national advertising, subsidizing equipment, and buying out competitor contracts. With high upfront investment on the part of carriers, customer credit quality and account churn (how quickly people leave the network after signing up) are critical measures for assessing revenue health.
Churn Rates
For the latest quarter each carrier reported its churn as follows:
| Ticker | Q3 2022 Churn Rate | Q3 2021 Churn Rate | Increase |
| VZ | 0.92% | 0.74% | 24.32% |
| T | 0.84 | 0.72 | 16.67 |
| TMUS | 0.88 | 0.80 | 10.00 |
| Average | 0.88 | 0.75 | 17.00 |
Source: EDGAR and my calculations.
To interpret what this means, VZ is losing less than 4% of its customers annually based on its Q3 2022 Churn Rate (4 x 0.92%), or better than 96% retention rate. Looked at another way, it takes 25 years for Verizon to completely turnover its customer base, or an average life of 12.5 years per customer. That’s great overall loyalty for any business.
2022 has seen a rise from middle of the pack to the highest churn rate for Verizon, which could cause concern if it materially worsens over time. Much of the increase was driven, according to VZ management, by rising rate plans that were not followed by its competitors. We theorize that many price sensitive subscribers left for better deals, which likely improves VZ’s remaining subscriber credit quality (there is an inverse correlation between credit quality and price sensitivity.)
If, and it’s a real “if”, the migration away from Verizon was led by the most price sensitive subscribers, we can impute an overall increase to the credit quality underpinning VZ’s receivables mountain. Credit quality is going to be a big issue as we move through a recessionary macro environment.
Overall, we have some low-level concern over the churn rate without loud alarm bells ringing now.
Receivables Management
Although wireless carriers bill postpaid customers at the beginning of the month, the time to collect drains working capital. All three companies sell their receivables through a variety of conduits. Both VZ and TMUS use asset backed securitizations to convert receivables to cash. In some cases, these companies are able to make these financings non-recourse securitizations, which eliminates any need for VZ or TMUS to “top up” asset values when defaults increase. That’s a big plus and a very positive statement about the quality of these receivables.
Among the big three carriers, Verizon touts its superior credit management. When we look at all 3 competitors’ receivables management, we find the following for Q3 2022:
| Ticker |
Receivables ($MM) |
Reserves for Losses ($MM) | Receivables/ Revenues | Avg Collection Days | Reserve % |
| VZ | 24,475 | 805 | 71.48% | 65 | 3.29% |
| T | 646 | 37.90 | 34 | 5.68 | |
| TMUS | 4,324 | 161 | 22.20 | 20 | 3.72 |
| Average | 43.86 | 40 | 4.23 |
Source: SA, EDGAR and my calculations.
Verizon looks terrible with bloated receivables and under-reserved losses. Why is VZ so far off?
How receivables move off the balance sheet into securitization or factoring transactions distorts the collection days calculation in our opinion. More importantly, people actually paying is the key measure for this portfolio and something VZ’s Matt Ellis referenced at a recent Morgan Stanley Conference:
“When you look at the FICO score of our base versus others, you see the underlying quality of our base of customers and that leads to longevity of the relationships, which helps drive obviously, good financial outcomes.”
We do not have access to those comparative scores, so we take this comment at face value since Verizon sells its receivables into the asset backed securities market. Not getting the credit scores right will lead to securitization disasters, which we have not seen in the VZ portfolio.
On top of all that, let’s add that most people are reluctant to cut their data/voice access even when times are challenging. Although people will choose shelter, food and heat over data/voice when it comes to prioritizing expenditures in a recession, we see data/voice access as a prioritized expenditure unlikely to feel a material revenue pinch unless we have a deep recession (we see that as unlikely today).
While credit turnover is very slow for VZ today, the money comes in more reliably than AT&T’s and a little better than TMUS’ with respect to credit quality. We attribute some of that slower turn to Verizon’s B2B dominance. Good CFO’s do not pay bills early or even right on time unless you give them a good enough discount – instead they stretch vendors. Some of the largest, best-known corporations are notorious slow payers because they can be. You know the story about the 500-lb gorilla – he slow paid his bills.
Despite some redeeming positives, we are dinging VZ on this measure for being slower.
Capital Intensive Requirements
Unlike the old Ma Bell where one could only choose between a standard or a princess phone for the same wired connection (extra-long cords cost extra), today’s telecommunications are largely wireless, carry more data than voice traffic and equipment is available in an incredible array of sophisticated handheld computers/phones.
In a diverse world of network connections, network performance with respect to capacity, speed and reliability is a key differentiator where VZ excels. To keep that lead, however, requires more and more investment ahead of revenues. For example, it has taken years (because of the FAA and airline concerns) to rollout the 5G C-Band where VZ holds (and paid for) a dominant position.
Once deployed, Verizon will continue operating the finest national B2B wireless network, which is a growing sector in which VZ is the market leader. That also means, unlike so many mature businesses we follow, EBIT instead of EBITDA is the better free cash flow measure for valuation. While Depreciation and Amortization do not perfectly offset capital expenditures, they do provide an overall guide making EBIT our preferred metric when we value these three companies.
Business Segments
Consumer v. Commercial
We are concerned only with major segments in postpaid services for both wireless and wireline services among consumers and businesses (including government). Between the business and consumer segments, consumer is more than three times larger ($25,788MM v. $7,827MM in Q3 2022).
In the B2B segment, VZ’s Matt Ellis recently stated,
“We’ve got the 40% to 45% market share in B2B, and we certainly believe that we’re winning our fair share of gross adds and net adds in the industry as well. I mentioned earlier some of the things that are driving volumes in the industry. But I think what ultimately comes down to.
Wireless networks that support business activities depend on network quality, reliability and customer support of that network, obviously matters can be business critical. And therefore, why wouldn’t you buy the best network, the one that’s obviously got the long history of being the best network, and we see that in our business customers.”
That bodes well for both lower churn and a growing share in an area where price is not the primary consideration.
We see this as a big plus for VZ versus its competitors.
Wireless v. Wireline
Between Wireless and wireline (copper or fiber optic wires), wireless dominates even though VZ is adding subscribers to its FIOS fiber optic network that directly competes with cable, satellite and other telecommunications operators like AT&T. Between the two, wireline is the declining industry due to copper line replacement whereas wireless embeds more deeply into our homes and offices each year.
Business Segment Conclusions
Verizon’s dominant and still growing B2B share is highly defensive. Businesses cannot afford to have wonky wireless or wired networks. In my personal experience, Verizon does it better, at least in the super-competitive Southern California market where I live and work.
One of my businesses has been with Verizon for a decade. Three times in the last few years we tried to switch to T-Mobile by working through their internal business group. Each time TMUS failed because they repeatedly sent the wrong equipment and couldn’t fix it. The only member of our team who managed to get a working phone went to a retail store. T-Mobile runs the stores well but not business services support in our personal experience.
On the other hand, Verizon does a great and proactive job managing our business account through their business support group. My retail store experience for business services, by contrast, is pretty terrible. Whenever I’ve tried to use a Verizon retail outlet for business needs, it failed. The retail part works fine for me on the consumer side, but business accounts just confuse the folks who work in the stores in my experience.
Finally, AT&T has been perennially terrible for wireless in Southern California after it bought the old Cingular Network that was singularly bad in so many spots. AT&T has since improved, but does not approach Verizon’s reach in our personal experience.
We can see the differing operating priorities among these carriers. When we choose a defensive business model in which to invest for a recession, we prefer Verizon’s from a credit and entry barrier perspective (network quality and reliability scores by J.D. Power). Once the coming recession has passed, we forecast Verizon is likely standing taller due to a superior subscriber base and increased 5G capacity through the C-Band.
The C-Band
By now most people know that 5G is replacing the old 4G LTE as the preferred network. Within 5G, there is a band between the two WiFi MHz bands called the C-Band where Verizon controls almost 60%. This is considered mid-band or the sweet compromise between distance and speed and from where the most growth is forecast to come. C-Band’s rollout was held up over airline concerns about instrument interference. That has now been largely resolved and VZ is rolling it out.
Over 50% of VZ wireless subscribers own 5G devices already configured to use VZ’s faster network. As Verizon rolls out the service to more areas, those subscribers are upgraded to the faster network.
That faster speed means online data usage is forecast to soar. How that affects the bottom line is unclear with respect to operating margins. We do know that subscribers will choose faster speeds for a similar cost to support whatever data intensive use they demand, and that means 5G for wireless connections rolling forward.
Verizon is not really benefitting from its investment to acquire and build out its full 5G service today, and it is poised to reap those benefits for years to come unless some disruptive tech emerges.
We do not fully discount tech disruption in this space. After all, how many people forecast VOIP in 1996? Now, so much voice traffic travels that way because it costs less and fidelity is relatively high. Nevertheless, we see Verizon’s C-Band investment as a critical asset to be exploited more fully.
This is a key strategic positive for Verizon – an asset no one else has in as much abundance.
Valuation
We can see how Verizon is competitively positioned to outperform both T and TMUS as 5G becomes the US standard, but is the stock worth the bumpy ride?
For a business like VZ, we will look at its two closest rivals as well as a relative market expectation:
| Ticker | Enterprise Value (EV) | TTM* EBIT | EV/EBIT | Implied Annual Equity Return** | Current Dividend Yield | Expected Annual Return** |
| VZ | $341.68BN | $26.76BN | 12.77x | 7.83% | 6.59% | 14.42% |
| T | 311.93 | 33.09 | 9.43 | 10.61 | 5.91 | 16.52 |
| TMUS | 295.21 | 12.40 | 23.81 | 4.20 | 0 | 4.20 |
| Average | 15.33 |
Source: SA, EDGAR and my calculations.
*Trailing twelve months.
**The inverse of the EV/EBIT multiple.
What a mess. While AT&T has cleaned up its leverage act since spinning off Warner Bros, it has not yet proved it can focus better; and TMUS is materially understated because it doesn’t pay a direct dividend (it consolidates to its owner, Deutsche Telecom who paid dividends until last year). Additionally, TMUS has grown far faster than VZ or AT&T over the last 5 years:
|
VZ |
T* |
TMUS |
|
|---|---|---|---|
| Revenue Growth (‘YoY’) |
1.05% |
4.50% |
0.51% |
| Revenue Growth (‘FWD’) |
2.68% |
-10.55% |
6.70% |
| Revenue 3 Year (‘CAGR’) |
1.07% |
-5.21% |
21.58% |
| Revenue 5 Year (‘CAGR’) |
1.74% |
-0.68% |
14.85% |
Source: SA
*Warner Bros was spun out in 2022, which negatively impacts the FWD revenue growth number.
As we look at forecast revenue coming into 2023, we see a giant slowdown for T-Mobile. After a string of acquisitions capped by the Sprint merger several years ago, T-Mobile appears to be maturing in the U.S. even with 6.7% forecast growth for the next year. With similar operating margins to VZ and AT&T, TMUS simply looks very overvalued on a multiple basis. Even using EBITDA instead of EBIT leaves TMUS appearing overvalued.
When we look at Verizon versus AT&T, Verizon is the better built machine. Even though T is trading at more attractive numbers, we think a tougher operating environment will benefit VZ and TMUS more than T given their relative credit management standards. Also, AT&T management has (1) yet to prove it can operate a focused ship after disastrous forays into satellite distribution and content; and (2) a fundamentally riskier subscriber base, which we forecast will be more expensive to service in a recession.
Verizon appears attractively valued compared to its peers in a recessionary environment.
What about that “expected” 14.42% return for this year? It’s not actually expected, but simply an implied number based on the EBIT multiple – like a cap rate for real estate. With market forces pushing toward a consumer slowdown, we see margin pressure coming despite all of Verizon’s built-in advantages.
As subscribers pump more data through the fatter 5G pipe, it cannot charge for the incremental usage when so much of the market offers unlimited data plans. The value for Verizon, in our opinion, lies in its continued dominance in network quality and reach. As Verizon continues to compete well in the B2B segment, our buy case for VZ is entirely defensive in a Bear Market.
Verizon’s ability to pay and grow its dividend while ramping up its 5G network should improve Verizon’s already dominant overall market position in wireless services. We see far more upside than downside risk today.
Conclusions
We forecast a sideways stock market for the next few years. Finding businesses poised to prosper the next few years, and who meaningfully profit share with us through dividends, is our goal. Verizon with a current 6.59% yield and built-in path to 5G dominance in the US fits our bill for a defensive stock to buy and hold today.
Be the first to comment